Recovery Ahead?

If everything breaks right, the global economy could grow by 4 percent in 2011.

The outlook for the global economy in 2011 is, partly, for a persistence of the trends established in 2010. That means an anemic U-shaped recovery in advanced economies, as firms and households continue to repair their balance sheets, and a stronger V-shaped recovery in emerging-market countries, owing to their better macroeconomic, financial, and policy fundamentals. It adds up to close to 4 percent annual growth for the global economy, with advanced economies growing at around 2 percent and emerging-market countries growing at about 6 percent.

But there are downside and upside risks to this scenario. On the downside, one of the most important risks is further financial contagion in Europe if the Eurozone's problems spread—as seems likely—to Portugal, Spain, and Belgium. Given the current level of official resources at the disposal of the International Monetary Fund and the European Union, Spain now seems too big to fail yet too big to be bailed out.

The United States represents another downside risk for global growth. In 2011, the United States faces a likely double dip in the housing market, high unemployment and weak job creation, a persistent credit crunch, gaping budgetary holes at the state and local level, and steeper borrowing costs as a result of the federal government's lack of fiscal consolidation. Moreover, credit growth on both sides of the Atlantic will be restrained, as many financial institutions in the United States and Europe maintain a risk-averse stance toward lending.

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In China and other emerging-market economies, delays in policy tightening could fuel a rise in inflation that forces a tougher clampdown later. China, in particular, risks a hard landing. There is also a risk that capital inflows to emerging markets will be mismanaged, thus fueling credit and asset bubbles. Moreover, further increases in oil, energy, and commodity prices could lead to negative terms of trade and a reduction in real disposable income in net commodity-importing countries—while adding to inflationary pressures in emerging markets.

Furthermore, several major geopolitical risks loom, including military confrontation between North and South Korea and the lingering possibility that Israel—or even the United States—might use military force to counter Iran's nuclear weapons program. There are also the political and economic turmoil in Pakistan and the risk of a rise in cyber attacks—for example, in retaliation for criminal proceedings against WikiLeaks.

In the United States, slower private-sector deleveraging—given the fiscal stimulus from the extension of unemployment benefits for 13 months, the payroll-tax cut, and maintenance of current income-tax rates for another two years—could lull policymakers into assuming that relatively large fiscal and current-account imbalances can continue indefinitely. This could generate financial strains over the medium term and protectionist pressures in the short term.

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Finally, in the face of political opposition to fiscal consolidation, especially in the United States, there is a risk that the path of least resistance becomes continued monetization of fiscal deficits. Eventually (once the slack in goods and labor markets is reduced), this would push inflation expectations—and yield curves—higher.

But there are also several upside risks. The U.S. corporate sector is strong and very profitable, owing to massive labor shedding, creating scope for increased capital spending and hiring to contribute to more robust and above-trend GDP growth in 2011. Similarly, the Eurozone, driven by Germany, could lurch toward greater economic and political union (especially some form of fiscal union), thus containing the problems of its periphery. Meanwhile, growth in Germany and the Eurozone "core" may further accelerate given the strength of emerging markets, which may show even greater resilience, underpinning more rapid global expansion.

The attenuation of downside risks and pleasant surprises in developed and emerging economies could lead to a further increase in demand for risky assets (equities and credit), which would reinforce economic recovery via wealth effects and lower borrowing costs. Positive feedback from consumption to production, employment, and income generation—both within countries and across countries via trade channels—could further accelerate the pace of global growth, particularly if monetary policies in most advanced economies remain looser than expected, supporting asset reflation and thus demand and growth.

Indeed, after four years of either recession or sub-par recovery, the process of balance-sheet repair, while not yet completed, is under way, and may result in less saving and more spending to boost growth in advanced economies. The damage from the financial crisis is still ongoing, but stronger growth can heal many wounds, especially debt-driven wounds.

So far, the downside and upside risks for the world economy are balanced. But if sound government policies in advanced and major emerging economies contain the downside risks that are more prevalent in the first half of this year—which derive from political and policy uncertainty—a more resilient global economic recovery could take hold in the second half of 2011 and into 2012.